Regulatory Capital Requirements for Banks: A Complete FRM Guide

Regulatory capital requirements form the backbone of banking regulation, ensuring that banks hold sufficient loss-absorbing capacity to protect depositors and maintain financial stability. This guide covers the key capital concepts every FRM candidate must master.

Why Do Banks Need Regulatory Capital?

Banks operate with high leverage — a typical bank's assets are 10–15 times its equity. This leverage amplifies both returns and losses. Regulatory capital requirements exist to:

• Absorb unexpected losses without triggering insolvency
• Protect depositors and the deposit insurance fund
• Maintain confidence in the banking system
• Reduce moral hazard created by the "too big to fail" perception

The Capital Structure Under Basel III

As we discussed in our Basel III guide, the Basel framework defines a tiered capital structure:

Common Equity Tier 1 (CET1)

The highest quality capital — fully loss-absorbing on a going-concern basis:

• Common shares
• Retained earnings
• Accumulated other comprehensive income (AOCI)
• Minority interests (with conditions)

Minimum CET1 ratio: 4.5% of Risk-Weighted Assets (RWA)

Additional Tier 1 (AT1)

Going-concern loss-absorbing capital with no maturity:

• Perpetual contingent convertible bonds (CoCos)
• Non-cumulative perpetual preferred shares
• Must have write-down or conversion triggers

Minimum AT1: 1.5% of RWA (total Tier 1 = 6%)

Tier 2 Capital

Gone-concern loss-absorbing capital:

• Subordinated debt (minimum 5-year original maturity)
• Loan loss reserves (up to 1.25% of credit RWA)

Minimum Tier 2: 2% of RWA (total capital = 8%)

Capital Requirements Summary

Capital Buffers

Basel III introduced four capital buffers above the minimums:

Capital Conservation Buffer (CCB)

• 2.5% CET1 above minimum requirements
• Creates an effective CET1 minimum of 7%
• Restrictions on distributions (dividends, bonuses) when buffer is breached

Countercyclical Capital Buffer (CCyB)

• 0–2.5% CET1, set by national regulators
• Activated during periods of excessive credit growth
• Released during downturns to support lending

G-SIB Surcharge

• 1–3.5% CET1 for Global Systemically Important Banks
• Based on a scoring system considering size, interconnectedness, complexity, cross-border activity, and substitutability
• Currently 30 banks designated as G-SIBs globally

D-SIB Buffer

• Set at national discretion for Domestic Systemically Important Banks
• Typically 0.5–2% CET1

Effective Capital Requirements for a G-SIB

Risk-Weighted Assets (RWA)

Capital ratios are calculated as Capital / RWA. RWA reflects the riskiness of a bank's assets:

Credit Risk RWA

Two approaches:

• Standardized Approach (SA): Uses fixed risk weights based on asset class and external ratings
• Internal Ratings-Based Approach (IRB): Banks use internal models for PD, LGD, EAD to calculate RWA

Market Risk RWA

Under the FRTB:

• Standardized Approach: Sensitivity-based method with prescribed risk weights
• Internal Models Approach (IMA): Banks use Expected Shortfall models with regulatory approval

Operational Risk RWA

Under Basel III final reforms:

• Standardized Measurement Approach (SMA): Based on a combination of business indicator and historical loss experience
• Replaces the previous AMA (Advanced Measurement Approach)

Leverage Ratio

The leverage ratio provides a non-risk-weighted backstop:

$$Leverage; Ratio = \frac{Tier; 1; Capital}{Total; Exposure; Measure} \geq 3%$$

The total exposure measure includes on-balance-sheet assets, derivatives exposures, securities financing transactions, and off-balance-sheet items. G-SIBs face a leverage ratio buffer of 50% of their G-SIB surcharge.

Total Loss-Absorbing Capacity (TLAC)

For G-SIBs, the Financial Stability Board (FSB) requires:

• Minimum TLAC: 18% of RWA (plus buffers) and 6.75% of leverage exposure
• Eligible instruments: Capital + certain senior unsecured debt with bail-in features
• Ensures sufficient resources for resolution without taxpayer bailouts

Output Floor

Basel III final reforms introduce an output floor requiring that:

$$RWA_{Internal; Models} \geq 72.5% \times RWA_{Standardized}$$

This limits the capital benefit banks can derive from using internal models, addressing concerns about excessive variation in risk weights across banks.

FRM Exam Essentials

Regulatory capital is tested extensively in FRM Part 2. Key areas include:

• Capital tier definitions and qualifying instruments
• Minimum ratios and buffer calculations
• RWA computation under standardized and IRB approaches
• Leverage ratio calculation and purpose
• G-SIB identification and surcharge methodology
• TLAC requirements and resolution planning
• Output floor rationale and impact

Mastering regulatory capital concepts is essential for FRM Part 2 success and for any career in bank risk management!